FX Options Skews: A Complicated Story

A new research note from CME Group looks at whether FX options skews can be used to predict where certain currencies will move relative to the US dollar.

Written by Erik Norland, executive director and senior economist at CME, the research opens by explaining that options markets typically exhibit a skew, but that in different asset classes this skew can be in different directions.

For example, Norland points out that out-of-the-money (OTM) put options on equity index futures are usually more expensive than OTM call options because investors fear a sudden decline in stock prices more than a sudden rise. However, the reverse is generally true for options on agriculture products because food buyers are more concerned with a sudden increase in the price of crops rather than a decline.

With regards to skews, the picture in FX is more complex as it varies according to what particular currency is under the microscope. The CME notes that amongst the major currencies, EUR, AUD and CAD tend to skew negatively versus USD – meaning that OTM put options are usually more expensive than OTM calls – whereas JPY and CHF tend to have the opposite skew.

“For all six currencies, the degree of skewness varies over time, driven to a large extent by two factors: interest rate differentials and political risks,” says Norland in the report.

The research shows that the degree to which OTM call options on JPY or CHF are expensive or cheap versus OTM puts is closely related to the interest rate gap between these currencies and USD, highlighting that when US rates are higher than Japanese or Swiss rates OTM calls tend to be more expensive.

AUD and CAD, by contrast, normally skew the opposite way as investors are almost always more concerned that these currencies might suddenly fall relative to USD. Norland says that the degree of skewness does change according to the interest rate differential though, pointing out that from 2007 to 2012 US short-term interest rates were much lower than Australian equivalents and AUD put options were typically more expensive than calls, but that following this period, the gap narrowed and eventually went the opposite way, with USD rates exceeding AUD ones. Since the US Fed’s tightening cycle got underway, the Reserve Bank of Australia (RBA) has been easing policy and AUD options markets have shown only a small downside in skewness.

Norland explains that CAD exhibits similar characteristics, except that Canada had a smaller interest rate gap with the US before 2015 than did Australia and CAD showed a milder downside skewness.

“With Australian and Canadian short-term interest rates now above those of the US, one might imagine that their OTM calls might become more expensive than their OTM puts, showing positive skewness. This hasn’t happened yet. The reason being that USD is still the global reserve currency and still tends to benefit from flight-to-quality events when investors flee risky assets. Often in such de-risking/flight-to-quality events, not only do equities decline, but commodity prices also follow on the downside. Weaker commodity prices are usually bad news for AUD and CAD, given that both nations are significant exporters of natural resources. Moreover, with JPY, CHF and EUR available as cheaper funding currencies, investors are probably not actively borrowing in AUD or CAD to lend elsewhere,” he says in the report.

Until the recent tightening cycle in the US, interest rates in the UK and Eurozone had been more in-synch than these other countries, meaning that politics has been the main driver of changes in call versus put options skewness in GBP and EUR against USD.

The data Norland presents shows that GBP was very negatively skewed versus USD in the run up to the referendums for Scottish independence in 2014 and Brexit in 2016. Similarly, EUR showed extreme downside skewness during the acute phase of the Eurozone debt crisis back in 2011 and 2012, and once again in 2017 just before the French Presidential election.

“Both currencies typically show negative skewness versus USD with OTM puts somewhat more expensive than OTM calls. This too reflects the central role of USD as the primary global reserve currency and a more likely beneficiary of a flight-to-quality rally than either EUR or GBP,” says Norland in the research note.

Having established these trends in currency options skews, the piece then looks at the degree to which they can be used as indicators of whether a currency is likely to appreciate or depreciate. To do this, Norland and his team indexed the skewness on a scale of 0-100 over rolling two-year periods and compared it to the return of the currency versus USD in the subsequent three months.

“For example, if the currency option skewness was the most skewed to the downside it had been during the previous two years, the index would have a reading of zero. If the currency option market was the most positively skewed that it had been during the past two years, the index would have a reading of 100. We then broke the results down into deciles and looked at the subsequent three-month performance of the reinvested currency future rolled 10 days prior to expiry from 2008 until early 2019,” explains Norland.

The results of this analysis were a pretty mixed bag. For CAD, EUR and GBP, options skewness has been a decent, but in some cases imperfect, indicator of where the market is going, notably options traders got the UK Brexit referendum right, when there were big downside risks to GBP.

But for AUD options, skewness was not a consistent indicator of future returns against USD. Greater-than-average downside skewness was often a buy signal, whereas greater-than-average upside skewness tended to be a sell signal. However, this trend disappeared when skewness was at its most extreme to both the upside and downside.

Similarly, CHF and JPY options skews weren’t a good indicator of market movements, although Norland has a theory about why this was the case for the former of the two.

“For the franc, this may be partly because its options happened to have an exceptionally positive skewness in 2011, when the SNB took the market by surprise by capping its value versus EUR at a lower level than where it had been trading. This decision was extremely costly to anyone who was long the currency at the time and expecting further appreciation. After a long period of relatively average risk, with the options market neutrally positioned relative to its recent average, the SNB suddenly lifted the cap in January 2015, sending CHF soaring, putting a large upward bulge in the middle of our chart. Had it not been for the SNB’s extraordinary interventions, the overall results for the franc would have looked much more like that of EUR and GBP,” he says in the research.The research subsequently ends on a slightly strange note.

Firstly, having done the hard work of piecing together the relevant data and writing the report, Norland insists that the research presented should be “taken with a large grain of salt”. This might be a caveat required by CME’s legal team, but Norland notes that this analysis is time sensitive and that past average relationships should not be expected to hold in the future.

Secondly, having established that options skewness is not a particularly useful indicator of where currency values will head in the future, Norland nonetheless recommends that currency traders, regardless of whether or not they trade options, might want to consider options skewness as they manage their portfolios.